“Capitalization Rate,” is a fundamental real estate valuation ratio that compares a rental property investment’s annual net operating income (NOI) to its current market value.
The cap rate formula is the ratio between the net operating income (NOI) of a rental property and its fair market value (FMV) as of the present date, expressed as a percentage.
What are Cap Rates in Real Estate?
The cap rate, an abbreviation for “capitalization rate,” is a real estate metric that reflects the expected rate of return on rental property investments.
The commercial real estate (CRE) market participants must closely weigh the risk-return profiles of potential investments to determine the purchase price at which the target yield is attainable to guide their investment decision-making process.
Cap rates are the primary shorthand by which different properties with comparable risk-return profiles can be analyzed side-by-side.
Cap rates in real estate estimate the rate of return on rental properties based on their perceived income potential.
The NOI of the properties must be expressed on a pro forma basis to reflect the income that the properties expect to generate at stabilization.
Stabilization refers to the state at which a real estate development project or acquisition is near complete, and the property is close to fully functional, with the rental units of the property leased near full occupancy with rent prices close to the market rate.
By converting the NOI of a property into a percentage, the cap rate is a standardized metric that facilitates “apples-to-apples” comparisons between comparable properties to identify the investment opportunities that offer attractive risk-return trade-offs.
How to Calculate Cap Rate?
The cap rate is calculated by dividing the net operating income (NOI) of a rental investment property by the market value of the property as of the present date.
The net operating income (NOI) and property value are the two inputs in the cap rate formula:
Net Operating Income (NOI) - The net operating income, or “NOI,” represents the income potential of a property based on its core drivers of revenue, such as rent payments, minus its operating expenses, e.g., maintenance costs, property taxes, and insurance.
Property Value - The current market value, on the other hand, is the property’s fair market value (FMV) as of the present date. The fair value is determined in an independent appraisal and is intended to reflect the current value of the property rather than the original purchase price.
The NOI used to analyze the capitalization rate of rental properties must be stabilized to reflect their “steady-state” performance, wherein the operations of the properties are functional and starting to generate rental income.
The step-by-step process to calculate the cap rate is as follows.
Calculate the Net Operating Income (NOI) of the Property at Stabilization
Determine the Market Value of the Property as of the Present Date
Divide the Property’s Annual NOI by its Current Market Value
Multiply by 100 to Convert from Decimal Notation to Percentage Form
Cap Rate Formula
The formula to calculate the cap rate is the net operating income (NOI) of the property divided by the present market value of the property.
Net Operating Income (NOI) - The NOI of a property investment equals the sum of the property’s rental income and ancillary income, net of any direct operating expenses incurred.
Property Value - The property value refers to the current market value of the property as of the present date, i.e., the fair value of the property. Or, the property’s purchase cost can be used depending on the context of the analysis.
The formula to calculate the net operating income (NOI) is the sum of the rental and ancillary income, less direct operating expenses.
Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
The NOI can also be computed by subtracting a property’s effective gross income (EGI) from its direct operating expenses.
Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses
Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses
Potential Gross Income (PGI) = (Total Number of Units × Annual Market Rate Rent) + Other Income
Does Cap Rate Include Mortgage Payments?
One of the more common questions regarding the capitalization rate received by students and trainees is, “Does the cap rate formula include mortgage payments?”
The answer? No, the cap rate calculation does not include mortgage payments or interest on real estate loans.
The rationale for the capitalization rate metric neglecting mortgage and interest payments is that those spending activities are categorized as financing costs rather than operating costs.
Cap rates are thus an unleveled measure of returns used to analyze individual investment properties and perform comps analysis.
Financing Structure - The funding sources of the real estate project are at the discretion of the new investor post-closing, so the prior capitalization does not matter, for the most part.
Unlevered Return Metric- Since the effects of debt financing are neglected in net operating income (NOI) – unlike financial metrics such as net income – the cap rate is an “unleveraged” measure of returns suited for comparability.
NOI / Cap Rate Formula
Under the income approach, or “direct capitalization method,” the value of a real estate investment property is estimated by dividing the property’s net operating income (NOI) by its cap rate.
Property Value = Net Operating Income (NOI) ÷ Capitalization Rate
For example, if an investor owns a property generating $3 million in annual net operating income (NOI), yet comparable properties trade at only 6.0% cap rates – perhaps because of more risks with these types of properties – the investor can use the capitalization rate derived from the peer group to guide the pricing analysis.
Given the 6.0% capitalization rate, the pricing of our property investment should be near $50 million.
Property Price = $3 million ÷ 6.0% = $50 million
Likewise, multiplying the NOI by the net operating income multiplier ($50 million ÷ $3 million) yields the same property value.
Property Price = $3 million × 16.7x = $50 million
Commercial Rental Property Cap Rate Calculation Example
Suppose a commercial real estate investment firm performs diligence on a commercial rental property that generates $1.2 million in net operating income (NOI).
The commercial real estate (CRE) rental property is currently available for purchase on the market, with the asking price set by the seller at $10 million.
Property Asking Price = $10 million
Net Operating Income (NOI) = $1.2 million
Given the asking price of $10 million and annual NOI of $1.2 million, what is the implied cap rate?
The property asset value of the commercial real estate investment equals the property’s NOI divided by its current market value.
The formula can be rearranged to solve for the implied cap rate, which comes out to 12.0%.
Property Value = Net Operating Income (NOI) ÷ Cap Rate (%)
$10 million = $1.2 million ÷ Cap Rate (%)
Cap Rate (%) = $1.2 million ÷ $10 million = 12.0%
If you’re more familiar with the EV/EBITDA multiple, the closest thing to a cap rate is an inverse EBITDA multiple.
Why? The net operating income (NOI) is a measure of profitability with numerous similarities to the EBITDA metric.
Therefore, if we multiply the commercial real estate (CRE) property’s NOI multiple by annual NOI, the implied value of the property comes out as $10 million like before.
NOI Multiple = $10 million ÷ $1.2 million = 8.3x
Property Value = 8.3x × $1.2 million = $10 million
The annual return is $1.2 million, so the number of years for the investment to reach its breakeven point is estimated to be around 8.3 years.
Annual Return = 12.0% ÷ $10 million = $1.2 million
Number of Years to Breakeven = $10 million ÷ $1.2 million = ~8.3 Years
What is a Good Cap Rate?
Understanding the core determinants of a property’s cap rate is necessary to analyze changes over time and interpret data correctly.
So, what are the underlying factors that can cause the cap rates of rental properties to increase or decrease?
High Cap Rates - If capitalization rates increase, property prices might be falling (or stagnating). Otherwise, the potential cause could be rent is rising at a faster pace than property values. High cap rates generally imply higher risk and, thus, higher potential returns.
Low Cap Rates - On the other hand, property prices rise faster than rents if capitalization rates are falling. Low cap rates tend to suggest the investment is less risky, which coincides with lower returns.
That said, the higher the cap rate, the higher the annual return on investment (ROI) – all else being equal.
Generally speaking, a “good” cap rate ranges between 4% and 10%, but the target return is contingent on the property type, location, and current market conditions.
The target cap rate is specific to the real estate property investor and is subjective for the most part, so there is no industry standard for the minimum “hurdle rate” to invest.
Why is a Higher Cap Rate Riskier?
The cap rate is a measure of returns, so the metric is also a measure of risk since risk and return are two sides of the same coin.
So, is it better to have a high or low cap rate?
In short, the answer is rather nuanced and entirely dependent on the investor (and surrounding circumstances).
Contrary to a common misconception, a higher cap rate is not always better nor preferred by real estate investors.
The reason? Higher cap rates are often achieved by investing in riskier properties, so a trade-off between risk and return must be understood.
A higher capitalization rate implies more risk attributable to a real estate property investment (and vice versa for a lower capitalization rate). That said, a real estate investment firm’s priorities ultimately determine its target capitalization rate:
Yield vs. Capital Preservation - Certain real estate investors prioritize capital preservation – i.e., minimizing the risk of capital loss on an investment – whereas others are more yield-oriented and set a higher bar for the required rate of return.
Risk Appetite - The risk tolerance varies by the investor, which goes hand-in-hand with the prior factor since more risk should correspond with higher returns to compensate the investor for undertaking the incremental risk (and vice versa).
For instance, a risk-averse real estate investor pursuing a long-term, steady stream of income is likely to prefer properties with lower capitalization rates located in stable markets instead of riskier properties with higher cap rates.
What Does a 7.5% Cap Rate Mean?
For example, suppose a $2 million real estate property is expected to generate $150,000 in annual net operating income (NOI) at stabilization.
Property Value = $2 million
Net Operating Income (NOI) = $150,000
Given the NOI and property value assumptions, we can input those figures into our capitalization rate equation, resulting in an implied capitalization rate of 7.5%.
Capitalization Rate (%) = $150,000 ÷ $2 million = 7.5%
So, what does the 7.5% cap rate mean?
The 7.5% cap rate means that an investor should expect to earn a 7.5% annual return on the investment property or an annual return of $150,000 in dollar figures.
Annual Return @ 7.5% Cap Rate = 7.5% × $2 million = $150k
Given the annual return of $150k, the investor should expect to recoup the initial contribution in approximately 13 years, i.e., the time required for the investment to reach the breakeven point, where the property starts to pay for itself (Cumulative Return = Purchase Cost)
Number of Years to Breakeven = $2 million ÷ $150k = 13.3 Years
Cap Rate Compression vs. Expansion: What is the Difference?
If the cap rates in a particular real estate market decline, the market is said to be in a state of “cap rate compression.”
Conversely, if the cap rates rise instead, the market is undergoing “cap rate expansion.”
The cap rates on rental properties and the property values are inversely related.
Cap Rate Compression - Increase in Property Values (or Rise in Purchase Prices)
Cap Rate Expansion - Decrease in Property Values (or Reduction in Purchase Prices)
As a general rule of thumb, a market exhibiting cap rate compression should be expected to observe rising property asset values – all else being equal.
However, contrary to a frequent misconception, lower cap rates do not simply mean less risk in a potential investment.
While the statement can be true in certain scenarios, there are exceptions in which the cap rates decline following a widespread increase in property asset values.
Inflated property valuations in irrational markets often coincide with market factors that contribute to lower returns earned by real estate investors.
Higher Purchase Price - A real estate market with high property valuations is characterized by higher purchase prices by new investors (i.e., higher risk of overpaying for the asset)
Market Competition - Competition among buyers and investors tends to cause property valuations to rise, often to an unreasonable level (i.e., seller’s market) – all else being equal. Therefore, the purchase price paid by the investor or buyer likely contains a significant purchase premium, referred to as the “winner’s curse” in M&A.
Market Cyclicality - Often, investing at the “peak” in a cyclical market or attempting to profit from short-term trends can cause real estate investors to incur significant losses.
The preferred scenario, in which cap rate compression is unfavorable to investors, stems from a rise in property values without a proportionate increase in net operating income (NOI).
But if the net operating income (NOI) of the properties in the market either increases at a comparable pace (or perhaps even outpace) the recent rise observed in property values, the investment opportunities here could be worthwhile to pursue.